27 November 2008, Thursday

Everybody is asking whether it is the right time to invest in stock market. The argument in favor of investing right now is that Sensex is trading at an all time low and most of the stocks appear to be undervalued. So the enthusiastic buyers are in the favor of buying these stocks which have seen a fall of 40-90% in their values in the last one year. I do believe that a number of stocks are undervalued and will see a rise or bull run soon probably after mid January 2009. I would recommend buying defensive stocks (Power and FMCG firms) at the moment while avoiding stocks with high volatility. The following article will help you understand, analyze and pick good stocks from those currently trading on the stock exchange.

Before we move further lets think about this why do we invest in stock? How to invest in stocks? Which stocks to buy? When to buy or sell? Most people do not do the required analysis before making their investment decision. They generally follow the herd principle i.e. follow the crowd and buy what others are buying. This is the single biggest mistake one can make while investing their hard earned money. Studies after studies have indicated that retail investors generally invest when market is already pretty high or over-valued. Hence, they risk loosing their investment before the market corrects itself. But dont be mistaken that only normal and non-finance guys make such mistakes. Even highly trained, Ivy school business graduates end up doing the same thing!.

The rule of a successful investment is both an art and science. One needs to do the required technical (financial analysis) of the stock before buying or selling it. When to buy or sell probably is an art that comes with age and experience. In this article I have tried to help you understand the things you need to keep in mind while doing your research and number crunching. Remember there is no short cut to the investment.

Step-1: Before you decide to invest in a companys stock, find out how the company makes money

This is probably the easiest of all the steps. Do your due-diligence honestly. Read companys annual and quarterly reports, newspapers and business magazines to understand the various revenue streams of the firm. Stock price reflects the firms ability to generate consistent or above expectation profits/earnings from its ongoing/core operations. Any income from unrelated activities should not affect the stock price. For example- Unitech is second largest real estate firm in India. However, it has several other arms as well. It recently sold its wireless license to a foreign player. But it has not made a single penny from its telecom operation. Investors will pay for its earnings from its core real estate operations, which is its strength and stable operation, and not from the one-time sale of telecom license. Thus, you need to find out which operations of the firm are generating revenues and profits. If you do not know that you are bound to get a hit in future.

Warren Buffet once said that if you do not understand how a company makes money, do not buy its stock- you will always end up loosing money. He never invested even a single dime in technology stocks and yet made billions and billions of dollars both during tech bubble and bust.

Step-2: Find out which sector the company is in. Then, figure out what all factors affect the performance of the sector

First is to figure out which sector the stock is in. For example, Infosys is in IT services sector, NTPC is in Power sector and DLF is in Real Estate sector. Half of what a stock does is totally dependent on its sector. Hence, it is extremely important to understand the sector good and bad factors for the sector. Simple rule-Good factors help stocks while bad factors hurt stocks. Lets take an example of real estate sector. Factors that affect this sector are interest rates, economy and prices. If interest rates are high, buyers would not go for home loans and hence the demand for properties would be low. This would make the sector less attractive because there would be less scope of growth for the firms. Now lets talk about the airlines industry. The factors that affect it are fuel prices, growth in air traffic and competition. If fuel prices are high, tickets would be expensive and hence fewer people will fly. This will hurt the airlines sectors and firms equally.

The idea is to find out the good and bad factors for the sectors and figure out how much they will affect the stock and how. What we are really looking at are reasons that will make stock price good or bad or a company look more or less valuable, even though nothing about the company changes. This will give you a broader view whether the stocks will do well or poorly in the future.

Step-3: Examine the recent as well as historical performance of the stock and the company

By performance I mean both operational and financial performance of the company. Take out some time to find out how the company has done in its business over the years. Were there issues with its operations such as labor strike, frequent breakdowns, higher attrition or lagging deadlines? If any company has a history of serious problems, it does not make a good buy because chances are high it may have similar problems again. History is a good predictor of future! It is also extremely important to find out the historical financial performance of the company growth in revenues, profits (earnings), profit margins, stock price movements etc. Use the following table to understand the stock movement.